Dutch Supervision Culture and Basel IV

This week we saw some evidence that may point to a rift between the Dutch finance minister Jeroen Dijsselbloem and the Dutch central bank (DNB).

It has to do with Basel IV. This is an important regulatory push to harmonise bank supervision rules. About a year ago, the European Commission and European Bank supervisors started a coordinated effort to curb initiatives that would lead to higher capital requirements for EU banks. Former Commissioner Jonathan Hill initiated the curbing with a call for evidence and a consultation on the effects of higher capital standards on European bank lending. This, of course, is second-guessing at its best: before the entry into force of Basel III, many studies looked into the effects of higher capital requirements, see the MAG / LEI reports by the Basel committe and studies by (and referred by) Professors Anat Admati and Martin Hellwig. Overall, these studies pointed to one outcome: higher capital ratios are better.

Evidence or no evidence, others soon followed, see for example the Caught in the Middle speech by ECB’s top bank supervisor Sabine Lautenschläger, which identifies the lack of banks profits as a threat for financial stability.

The main reason to curb efforts that aim to shore up regulatory capital is the poor state of EU banks. These are not very profitable. The prospects of profitability are dim, and likely will remain dim if we believe this report. So, Europe has decided to allow its banks to become a bit riskier and rely on the risk-return relation to augment bank profitability and capital. (The alternative route of allowing banks to shrink their balance sheets is out-of-bounds of course, it has been outlawed on several occasions, see here, and here.)

Banks in the U.S., on the other hand, are profitable. For that reason, U.S. regulators can require banks to augment capital ratios, see this recent initiative promoting a stress capital buffer presented by Daniel Tarullo. Same story in Australia, on many occasions APRA communicated its policy to let banks repair the roof while the sun shines.

We are now at the point that the rift between the U.S. and Europe regarding Basel IV has become so serious that Europe apparently is willing to settle for an “agree to disagree” and go its own way.

“Not so fast!” this week said Jeroen Dijsselbloem in a laudable attempt to offer some context to this rift: “Some people don’t talk about the internal models, and just say the outcome may not be that the capital requirements go up – and I think that is the wrong approach, … If in an individual case it turns out that the internal models are not good enough then those banks will have to raise more capital.”

Dijsselbloem is right when he says that he wants the regulatory process to be a bit more open-minded, not rely in full on a pre-determined outcome of no change: “I don’t agree with the starting position of people who say the requirements shouldn’t rise. In that case we could just call off the whole exercise, and the weak spots in the internal models would remain hidden. I wouldn’t want that.”

Dutch minister of finance Dijsselbloem’s remarks are clearly at odds with the position of the Dutch supervisor. On the first day of the opening of the bank regulatory season (September 1st), the Dutch FD newspaper published and interview with business unit directors Olaf Sleijpen en Paul Hilbers, where Hilbers asserts that “the rules are made in Brussels, not in Basel.” Sleijpen backs Hilbers and claims that Europe is less and less inclined to blindly copy and paste international agreements into EU law. … Really?

Adding to the disagreement between DNB and the ministry of finance is the IMF’s financial stability report, which warns against weakening capital requirements:

Moreover, this week the authoritative Dutch Scientific Council of Government Policy (WRR) presented a report that concurs with the IMF. That report trashes the self-serving level playing field rationale used by bank capital doves: “In no way one shall worry about the international competitiveness of Dutch banks. … . Better capitalised banks are a source of strength for the banking system. It is in the interest of society.”

Why then would the Dutch bank supervisor accommodate banks? Unlike perhaps Italian and German banks, banks in the Netherlands are thriving. Profitability increased from 4% in 2014 to 7% in 2015, see data from DNB. The economy of the Netherlands performs well. House prices are back at pre-crisis levels. Rabobank last year claimed that the Dutch economy is poised to grow at a rate we would not have thought possible just a few years ago. The OECD agrees: “Economic growth is projected to remain sound, at around 2%, and broad-based.”

If DNB chooses to, it can require banks to repair their roofs: the sun shines! I mean, Hilbers and Sleijpen could have contacted the press to express their support for the Dutch finance minister, but no. Why?

An unusually lean organisation. The organisation of the Dutch central bank is exceptionally lean. Count the number unit managers on the DNB organogram and you will find about 100 of them. Combine that with the number of full-time employees of approximately 1.700 and you will find an implied managerial span of control of 17, which is about right for such an organisation. This means that there is likely only one (1) layer below the positions you see on the organogram: between any DNB employee and the executives at the top there are only one or two unit managers.

DNB looks also lean when we compare the organogram to results from a study by Raghuram Rajan and Julie Wulf. They show an average distance between divisional manager and CEO of 1.24. At DNB this is either 1 or zero if one takes into account that the DNB president is not involved in matters of supervision.

But lean organisations are great because they are less bureaucratic! Well, no, not really. Michael Handel, in a recent scientific article for example, finds no evidence favouring lean organisations. “Theories of lean management may have drawn overly general inferences from exemplary case studies and particular sectors or organisations that were notably over-bureaucratic.” So, when DNB flattened its organisational structure around 2004, it made an important decision based on just an idea: the idea that lean was the new black.

One problem of lean organisations is a lack of opportunities to train and vet managers. Lean organisations do not offer their managers sufficient opportunities to fail and learn from mistakes. A lean organisation also lacks the proper number of people who can vet or assess a candidate for a managerial position. This creates many unknowns: the manager does not know how and if he will perform; her/his managers probably have no clue about their direct report either. Consequently, these relatively inexperienced managers will produce surprises.

A don’t rock the boat culture. Making matters worse is a bank supervision culture that rewards managers for not rocking the boat or upsetting any of the banks that it supervises. Dan Davies has written a post on what is really wrong with bank supervision, which fittingly describes bank supervision culture as being one where your manager will stab you in the back when you rock the boat. Dutch newspaper FD agreed, not-rocking the boat is part of the fabric of DNB.

A culture that may have not changed. In 2010, the Dutch government instructed DNB to change its analysis-paralysis, no-rocking-the-boat-culture and take a more pro-active stance on supervision. However, changing culture is hard, especially if incentives, organisational structure, and career prospects don’t change accordingly.

There is evidence that the culture at DNB may have not really changed since 2010. A case in point is DNB’s controversial fit-and-proper test. Last year July, shareholder activist Pieter Lakeman published a truly scathing report on DNB’s fit and proper tests for bank employees.

Named and Shamed. Lakeman’s report extensively features the head of the unit that executed these fit and proper tests. Lakeman criticises and names this person. Shortly after publication of the Lakeman report and in line with Dan Davies expectations, the fit & proper unit head left.

(Interestingly, DNB’s publication of organograms may have merits in terms of transparancey, but it also makes clear to all of us who succeeds and who fails. Publishing organograms may be seen be as good practice. However, I am not so sure, organograms also highlight demotions and dismissals.)

Rock the boat at your peril. The combination of a lean organisation, which augments the risk of appointing inexperienced, incident-prone managers, and a culture that rewards not rocking the boat, makes that the key persons in charge of bank supervision are probably uninterested in taking a position that raises controversy. Even if they wanted to take a more audacious position on Basel IV, in a lean organisation, why would they?

About

ECB official dubs bitcoin ‘evil spawn of the financial crisis’ “I believe that ... Carstens summed its manifold problems up well when he said that bitcoin is ‘a combination of a bubble, a Ponzi scheme and an environmental disaster’.”
https://t.co/uB4WLySvcY via @financialtimes